Why Do We Use Debit Cards when Credit Cards Make More Sense?

Today, most people have debit cards, and many of those people also have credit cards. There is a paradox, though, which has stimulated a lot of research. Consumers are almost always better off paying with their credit cards than their debit cards. With a credit card, they can get rewards and the free use of funds for up to two weeks…. The growth of prepaid cards makes consumer choices even more puzzling: Why put out money sooner than you need to?

There are several answers to this paradox, which provide insights into how consumers use these products. One involves mental accounting. People use different payment instruments to help them sort out their budgets. They use debit cards for example, for the day-to-day necessities of life. They reserve credit cards for big-ticket items, even when they are planning to pay these off at the end of the month. Debit cards provide the same accounting function as cash and checks but the convenience of cards. A related point concerns double-entry mental accounting. People incur pain from paying and need to balance that off against the benefits they are going to receive. In many cases, they prefer to pay before they are consuming things, because then, they can consume pain free (What's with the need to punish ourselves?). Putting a payment on a credit card makes more sense from this perspective when the benefits are long-lived and off in the future.

Another answer concerns liquidity management. This explanation argues that there are perfectly rational reasons to use these different forms of payment. People receive payments in lumps – a weekly, bi-weekly or monthly paycheck, for example. They also face lumpy obligations, such as emergencies, home repairs and improvements, as well as having to buy consumer durables. Liquidity is costly to obtain, since it involves applications to lenders, and the approval and obtain of loans available is uncertain. Thus the use of debit and credit cards, as well as the decision to sometimes finance purchases, is part of household management.

Recent work in this area has focused on the paradox of “borrow high, lend low.” People have money in various demand deposit and savings accounts earning low interest while simultaneously carrying high-interest rate loans on their credit cards and other lines of credit. The average household spent $100 – based on data from the early 2000s – on interest payments they could have avoided by simply using funds from other accounts. This is really no different than businesses that have cash on hand while at the same time raising money from the bond and equity markets. The reason for it is that people value having enough liquidity to pay for lumpy expenditures and handle emergencies.

Credit cards are an important financial product, especially for Americans, as almost 80 percent of consumers have one. People have to choose among these relatively complex products and then make financing decisions. (Companies use uncertainty to confuse consumers and make products harder to compare with one another). This is probably one of the most controversial aspects of the behavioral economics literature. A fair reading of the literature to date indicates that many people choose credit cards intelligently and use them responsively. Recent papers have also found that people get better at making sound decisions over time. They get more experience and get smarter. At the same time, other people tend to be short-sighted, impulsive and over-optimistic about whether they will repay and their willingness to repay.

These customers can be the relatively more profitable ones for card companies, and that is the kind of person issuers pursue. Sophisticated consumers game the system, for example, by flipping balances between low-APR cards. Unscrupulous consumers pay their bills on time, get increasing credit lines and then play an endgame of tapping into those lines fully and defaulting. Meanwhile, unsophisticated consumers end up paying more in interest and fees than they would if they were smarter. In some sense, this is no different than many industries. Gullible car buyers end up subsidizing savvy ones.

Researchers have increasingly applied the theoretical and empirical techniques of behavioral economics to marketing and product design issues in financial services. One study looked at the effect of gifts on deposits. Working with a bank, the researchers did experiments involving different combinations of gifts. They found that giving people gifts increased balances, and the effects persisted for some time after the gifts. Importantly, the gift programs generated net present value, as the returns outweighed the cost of the gifts. Surprise gift programs were particularly effective. Banks should avoid starting out with a great gift if they cannot keep it up. People can look a gift horse in the mouth if it is a worse horse than they used to get.

The literature is mixed on whether particular payments instruments lift retail sales. A number of studies have found that people spend more if they have a credit card. Part of the explanation for this result is that credit tempers the pain of paying in our mental accounting. Cards can also reduce liquidity constraints and reduce transaction costs, which is a more traditional explanation. According to some anecdotes, New York cabbies have ended up getting bigger tips from riders that pull out plastic. A sophisticated experimental study found no evidence of credits cards increasing sales. The researchers rigged an insurance company cafeteria. Some employees were able to use a credit card to pay for their lunches, while others had to pay cash. There wasn’t significant difference in how much the two groups spent. Of course, this result may be specific for paying for a routine expense, such as having daily lunch.

Late fees really work at keeping cardholders in line, according to a study of 4 million monthly credit card statements. The authors found that penalty fees provided effective negative feedback. (see Anchoring on Minimum Payments). People who paid penalties for being late or over their limits were less likely to pay another penalty because they got their spending habits in order. Consumers are also forgetful. The authors found that the effectiveness of penalties declines by about 10 percent a month, as people forget about the pain. Behavioral economics has also analyzed the effectiveness of different types of advertising. One study experimented with different marketing messages for a lending product for more than 50,000 consumers in South Africa. It found that including a photo of an attractive woman increased demand as much as dropping the advertised interest rate by 25 percent. Giving people more choices decreased demand as did suggesting particular uses for the loan.

Source: http://www.thecatalystcode.com/theconversation/blog/2011/01/19/the-behavioral-economics-of-paying-and-borrowing/